I was blown away when I read this statement by Morgan Housel (emphasis added):
“Adjusted for inflation, the two stimulus packages passed in the last nine months are roughly equal to what we spent fighting World War II over two years.” – Morgan Housel
As much government spending as World War II. Wow.
Imagine the potential implications. Is it remotely possible that spending that much could, possibly, fuel a future surge in inflation? After WWII inflation surged to 28 percent in the last 6 months of 1946. Sure, there were other factors, like pent-up demand (sound familiar? How much traveling have you done lately?).
Not to be an alarmist, but of course it’s “remotely possible” we’ll see an uptick in inflation in the coming years.
It’s also remotely possible that your house will burn down.
I bet you have house insurance. But have you done anything to protect against inflation?
Today we’ll look at some investment options to protect against inflation. Inflation is a real risk, especially for those in retirement. Recognize the danger, and ensure you’ve got a plan to hedge your exposure.Inflation surged after WWII. Could it happen again after extensive stimulus spending? A remote chance, perhaps, but so is the risk of your house burning down. You have house insurance, right? Click To Tweet
Investment Options To Protect Against Inflation
Inflation has been unusually tame for the past decade, which is exactly why you need to start paying attention (remember “mean reversion”?). Here’s a chart of inflation since 2011, courtesy of usinflationcalculator:
Note, however, that the long-term rate of inflation is 3.1%, and anyone who believes in reversion to the mean (which includes me) knows that the risk of higher inflation is always lurking. Here’s the inflation rate by decade since 1913, courtesy of inflationdata:
Inflation is the Silent Killer of retirement, and if inflation returns to historical levels it can be devastating to your retirement. In a post two years ago, I challenged you to answer an “Inflation Quiz”. Most of you failed. Here was the question, and the
answers guesses you provided:
The Correct Answer: A $60k lifestyle in 1970 would cost you $213k in 1990, an answer only 19% of you chose. The rest of you failed the test, so let’s try again.
How much will a $65k Tesla cost in 30 years, assuming a 3% inflation rate (the long-term average). If you have a great memory, you’ll recall that I answered that question in the same article.
The Correct Answer: A $65k Tesla today will cost $158k in 30 years at a 3% inflation rate.
The tricky thing about inflation is that it’s almost invisible. Sure, you’ll have noticed those gas prices climbing in recent months, but it’s hard to grasp the overall impact inflation has on your cost of living over time. If we return to more historical rates of inflation, it’s something you need to concern yourself with.
Ignore inflation at your own risk.
Asset Classes To Protect Against Inflation
As you develop your asset allocation strategy for retirement, it’s critical that you keep inflation in mind. Paying for higher gas isn’t all that bad if your investments have kept up with inflation. It’s REAL returns you need to focus on, or the return of your investments after subtracting the inflation rate.
Google the term inflation, and you’ll find the following definition:
“Inflation: A general increase in prices and fall in the purchasing value of money.”
The trick is to find investments that offset that “fall in the purchasing value of money”. So, what are the best asset classes to protect against inflation? Here’s a summary of those most experts cite as being the most effective options in hedging your risk of inflation:
1. Real Estate
You always need a place to live, and real estate is perhaps the best inflation hedge available. Folks debate about “buy” vs. “rent”, but buying your home is one of your best moves to protect against inflation. With our retirement cabin paid for, I don’t really care how much housing prices increase. It simply doesn’t affect me. If we choose to move, the increase in our home’s value will allow us to buy another home that’s also increased in price. In the meantime, my housing cost is fixed (excluding property taxes and utilities, of course). That’s inflation protection.
Buying a rental home is also a viable strategy, and one of the reasons we recently bought a second home. Many people have built a successful retirement income stream based on rental income, which is a great way to protect against inflation. If inflation surges, rental prices will also likely increase. Sure, you’ve got the issue of dealing with renters and additional properties, but it’s a strong inflation hedge if you’re up for the related challenges.
If you prefer an easier route, consider REITs., or Real Estate Investment Trusts. We own Vanguard’s VGSLX REIT in our portfolio (we consider it part of Bucket 2 in our Bucket Strategy), and consider it as part of the 10% we target for “Alternatives” in our Asset Allocation strategy. REIT’s are easy to buy and sell, and avoid the hassle of property ownership. They also provide a decent dividend return which can be utilized for your retirement cash flow.
Finally, Peer-To-Peer lending is an option. We have a small position in PeerStreet (~1% of our Net Worth), primarily to gain firsthand experience with the peer-to-peer offerings. I’ve been happy with our position, which has earned a 6.7% return since we opened our account in 2016.
2. Precious Metals
In the 9th article I ever wrote, I answered the question “Should I Buy Gold?”. The answer I gave then is the same I’ll give now: “It depends” (read the article for more details). In summary, precious metals offer value in a diversified portfolio, but they need to be incorporated as a strategic element in your overall portfolio design, not simply purchased for speculation. I include my precious metals holdings in the 10% of my asset allocation that I target for “Alternatives”. Below are some of the ways you can invest in precious metals, and they can comprise a solid element in your plan to protect against inflation:
Physical Metal: I bought my first silver coins in 2011 and my first gold coins in 2014. I’ve added a small investment of “bunion” to our holding every year. I use APMEX for my purchases, the total of which is less than 1% of our Net Worth. There’s something reassuring about having a small stash of coins, and with the 2020 runup in gold and silver prices my returns have been good. I doubt I’ll ever sell them, and suspect my daughter will inherit them when my wife and I are gone. I enjoy it as much as a collectible as an investment, but owning precious metal coins does protect against inflation in the process.
Gold/Silver ETF’s: An easier (and more liquid) way of owning precious metals is to invest through an ETF that follows the Gold and Silver commodity price. The ETF Database has a great summary of these funds. For Gold, the largest is GLD, (1-year return 9.6%, 5-year return 41.2%) for Silver it’s SLV (1-year return 47.4%, 5-year return 71.1%). Don’t be seduced by those juicy returns, gold and silver ETF’s are notoriously volatile and should only comprise a small % of your overall portfolio.
Miner Stocks: Stocks of mining companies can either be purchased individually or via EFT’s such as GDX and GDXJ. Visual Capitalist did a nice infographic on the returns of various mining companies that comprise the GDX fund.
Full Disclosure: I trade GDX, GDXJ, NG, GLD and SLV in my “fun money” account at TDAmeritrade, the entire balance of which comprises ~3% of our Net Worth. These are some of my targets for options trading, which is beyond the scope of this article. To read about a simple options trading strategy, read “An Option Trading Strategy To Improve Your Returns.”
Commodities are the raw materials used to drive the world’s economy, from metal (copper, aluminum) to energy (oil, natural gas) to food to lumber. Commodity price trends can be a bit predictive for inflation since an increase in raw material costs is typically “passed along” through higher consumer good pricing, and is often a leading indicator of future inflation. Commodity prices, as you’d expect in a low inflation environment, have underperformed over the past decade. That’s the reality of a diversified portfolio and an indicator that they may perform well in a high inflation environment when other asset classes lag.
The easiest way to invest in commodities is via ETF’s, and there’s an ETF for almost any commodity you could dream of owning. Check out this list from ETF Database and enjoy your trip down a rabbit hole. I didn’t realize until doing this post that there’s even an ETF for aluminum, the industry where I spent my 33-year career. Hmmm…I may need to look into that one. I don’t own any commodities at the moment (I decided to sell any ETF’s that had K-1’s because I hate waiting at tax time), but have limited them to 1-2% of my overall portfolio in the past and considered them in the 10% of “Alternative” class in my asset allocation. Owning individual stocks of companies in the commodity space (e.g., XOM) is another viable option to invest in the sector.
Finally, a quick note about Crypto-currency. I haven’t included it specifically here, since I consider it primarily a speculative investment. That said, you could view it as an alternative currency class, which is typically considered in the “commodity” asset class. I would view it as a potential way to protect against inflation, but I’d prefer to see some of the speculative pricing swings settle down before I’d consider it a viable option.
4. TIPS & I-Bonds
I’m a big fan of TIPS and I-Bonds, and started buying my annual $10k allotment of I-Bonds in 2016, which I’ve continued every year on the treasurydirect.gov website. To see the difference between TIPS and I-Bonds, read this description from Treasury Direct. I’m not sure why I started with I-Bonds, and don’t view the difference between the two as particularly relevant (do your own homework, you may decide differently. There are differences, but that’s outside the scope of this article). Both are US government-issued bonds specifically indexed to inflation. Here’s how the mechanism works for TIPS (source: TreasuryDirect):
Twice a year, TIPS payout on a fixed rate (note, I-bond income isn’t realized or taxed until you sell, that’s one of the differences). The principal value of TIPS changes based on the inflation rate, therefore, the rate of return includes the adjusted principal. If, for example, you purchased a $10,000 bond paying 2% interest, you’d receive $200/year. If inflation surges to 5%, the principal value of your TIP bond would increase 5% to $10,500 and pay your interest based on that higher amount. So, instead of $200, you’d receive $210. Unlike “normal” bonds which typically decline in value in inflationary times, TIPS increase in proportion to inflation. I can’t imagine a much better way to protect against inflation.
While we could, theoretically, purchase up to $20k/year of I-Bonds (both my wife and I could buy our $10k allotment), an annual $10k purchase fits well with our bucket strategy (part of Bucket 2) and makes a predictable bond ladder in the future years as the bonds mature (you can redeem I-bonds without penalty after 5 years, but they’ll continue to pay interest for 30 years, offering nice flexibility as you design your future retirement income streams).
5. Delay Social Security
The final option I’ll review to protect against inflation is to delay your social security, which I outlined in “Should You Take Social Security at Age 62 or 70?” Rather than rehash the details of this strategy, I’d encourage you to read that article. In summary, your Social Security payment increases annually with inflation. By delaying your social security, your “denominator” is larger than if you claim early, so your annual inflation increases result in a larger dollar increase to help offset inflation.
In closing, some folks have asked me about the effectiveness of stocks as an inflation hedge. I’d place them at #6 or #7 (if I included Farmland, which I considered), but had to cut off the list somewhere. If you’re interested in solid dividend stocks (my preference as an inflation hedge), check out Sure Dividend’s posts: Dividend Aristocrats List, Top 4 Stocks to Start Your Retirement Portfolio, and How To Build Your Dividend Growth Portfolio. All represent some very solid writing from a smart blogger who focuses on dividend investing.
Just because inflation has been dormant for years doesn’t mean it will stay that way. Recognize the threat that inflation has on your retirement lifestyle, and think through your strategy for how you plan to protect against inflation. Left unguarded, it could cause a lot of pain.
Kind of like having your house burn down.
You may want to consider buying some insurance.
Your Turn: Do you think about inflation as a risk during your retirement? Do you have any investments that mitigate your risk? Let’s chat…